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Fundamental Analysis > Valuation > Flashcards

Valuation Flashcards

1
Q

Valuation is a powerful predictor of XXXX XXXX Returns, but its power diminishes as the time horizon XXXXXX

A

powerful predictor of the LT

Diminishes as time horizon shortens

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2
Q

All assets are valued xxxxxx each other

A

against

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3
Q

Higher interest rates put xxxxx pressure on business values, due to the relative attractiveness of bonds

A

higher interest rates put downward pressure pressure on the value of businesses.

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4
Q

Lower interest rates put xxxxx pressure on business values, due to the relative lack of attractiveness of bonds

A

upward pressure

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5
Q

What is the 5 year projection rule?

A

1) Average EPS growth rate last 10 yrs
2) Project next 5 yrs via same gth rate to establish Y5 EPS
3) Multiply 10 yr average PE x Y5 EPS to get a target stock price.

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6
Q

What does it mean to like to buy stocks trading at a discount to their growth rates?

A

We like it when a stocks is growing at 25% but its PE is 16x versus one growing at 16% with a PE of 25x.

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7
Q

Why is earings predictability so important to valuation?

A

The more predictable earnings are, the less variability in forecasts and the easier it is to ascertain future value.

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8
Q

How can we quickly compare a companies rate of return to bonds?

A

We take the current EPS and divide by the stock price to get an earnings yield, aka a ROI or ROR.

We can then compare this plus a dividend yield to a bond yield to ascertain relative value.

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9
Q

How can we evaluate the current expectations for a stock?

A

We use the current price and run scenarios to find out what level of revenue growth, margins and earnings and cashflow growth are currently embedded.

Then we can decide whether that is realistic or not

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10
Q

What are the two parts that make up a valuation?

A

The current net worth or value of the net assets and the future earnings power of the business (cash that can be generated).

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11
Q

How can we use the FCF yield to compare to bonds?

A

In the same way we can use the Earnings yield on a stock to compare to bonds, we can use the FCF yield on a stock to compare to Bond yields.

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12
Q

What is owner earnings?

A

NI + Deprecn + Chg WC - Capex - Stk Based Compensation (no cash outlay)

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13
Q

What is FCF?

A

A common measure is to take the earnings before interest and taxes multiplied by (1 − tax rate), add depreciation and amortization, and then subtract changes in working capital and capital expenditure.

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14
Q

When are FCF and Owner earnings likely the same?

A

For large stable companies

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15
Q

In what ways is a cash yield flawed?

A

It is useless for fast growing companies

It ignores the NWC of a business.

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16
Q

In what way can we compare LT cash generation to a businesses capital intensity?

A

We look for 10-15 years of financial statements and look at the amount of FCF produced over that period versus the amount of capex spent over that period.

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17
Q

What are three different ways we can come up with a discount rate for discounting cash flows?

A
  1. Use the current 10 yr/30 year bond yield (buffett)
  2. Use a yield approprate for a company of a similar credit rating
  3. Use your own rate of return requirements.
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18
Q

What is the extra step that buffett uses beyond discount rates?

A

He uses a margin of safety

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19
Q

What is a Buffett hurdle rate?
What is the rough Buffett hurdle rate today?
what was it in the past?

A

That means that the price he pays for the investment today has to deliver him at a minimum a 10% cagr pa into the future.

Today he uses close to 10% but in the past used 15% hurdle rate.

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20
Q

How can we use different levels of margin of safety?

A

for larger companies with safer cashflow [strong moat predictable] and industry leaders we can use a MOS of 25%.

If we are talking about a company with higher growth expectations then we would want to use a MOS closer to 50%.

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21
Q

What is the forward sales and structural margin methodology for establishing value?

A

Take forward sales and structural margin of X and calculate out op profit.

Then take tax away

Discount the result to infinity at Y% growth rate and Z% wacc (ie post tax ebit / (Growth - wacc))

Take away debt or add back net cash

Add back share in associates

Divide final figure by no of shares to get Implied value.

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22
Q

Buffett likes to talk about buying whole businesses (thinking about their mkt market cap or EV) because it gives insights into what their XXXXXX, XXXXXX, XXXXXXX should be compared to other investments

A

Earnings, cashflow and returns should be versus other investments.

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23
Q

The Greenblatt magic formula uses two main pillars. What are they?

A

Earnings Yield

Return On Capital ((ROC))

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24
Q

How does the magic formula calculate Earnings Yield

A

EBIT/EV

EV = EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

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25
Q

How does the magic formula calculate ROC?

A

EBIT/Tangible Capital Employed (Net Working Capital + Net Fixed Assets)

net working capital calculation are cash, accounts receivable, inventory, and short-term investments.

Net Fixed Assets = FA - Accum Deprecn

26
Q

Using the magic formula how can the EBIT be adjusted?

A
  1. Normalized earnings
  2. Trailing Earnings
  3. Estimated Earnings
  4. Earnings 3-4 years out.
27
Q

What is the John Neff total return ratio?
How should it compare to the markets TRR?
What is the minimum level of EPS growth he is looking for?

A

He estimates a companies earnings growth rate, adds it div yield and divides by the stocks PE ratio.

He is looking for a total return ratio of at least 2x what the market score is.

He looks for companies with a minumum EPS growth rate of 7%.

28
Q

What level of P/BV is appropriate for a certain level of ROE?

A

6% ROE = 1x BV
12% = 2x BV
18% = 3x BV
24% = 4x BV

29
Q

Why would EV/Sales be considered better than a PE multiple?

A

Because the PE can be significantly impacted by accounting policies while the EV/Sales cant be.

Hence we can more easily compare companies.

30
Q

Why is price to sales considered an apples to oranges comparison?

A

In the P/S calc, the P belongs to equity holders but the S, because its pretax, has not paid interest and therefore belongs to both equity and debt holders.

This is why EV/sales is considered a better metric

31
Q

How can we use EV/Sales to come up with a range of values for a company?

A
  1. Find industry peers, establish a median ev/sales multiple
  2. Put bear and bull multiples around that
  3. Using current or projected sales multiply by all three EV/sales scenarios to come up with 3 projected EVs
  4. For each scenario take away take away debt and cash to come up with an equity value.
  5. Divide by total shares outstanding
  6. End result Bear, Mid and Bull value for company
32
Q

What is the rule of thumb for EV/sales based on a companies Ebit margin?

A

A company should trade on the ebit margin/10.

5% ebit margin = 0.5x EV/sales
10% = 1x
20% = 2x

33
Q

What is the value of a firm?

A

the present value of all future cash flows discounted by the required rate of return (RRR).

34
Q

How does the required rate of return (RRR) impact valuation? How does this differ for equity and debt?

A

The smaller the required rate of return the higher the value. So, if you use equity only, the required rate of return is high, thus a lower value. The more debt you have the higher the value because of the tax shield, i.e., cost of debt is cheaper than anything else.

35
Q

What is the impact of debt on RRR and value of a company?

A

the problem is that more debt puts financial stress on the company, which raises the required rate of return on equity (equity providers start wanting higher rate to offset the increased risk). So, you have to somewhoe balance the two to get to the optimal required rate. Even if you pay interest on debt, it is stil cheaper than getting money from equity holders who get to share in the profits with you.

36
Q

Difference Between Levered and Unlevered Free Cash Flow

A
  • Levered free cash flow refers to the amount of funds that is left over once debt and interest on debt have been paid. It is calculated as; Levered free cash flow = unlevered free cash flow – interest – principal repayments.
  • Unlevered free cash flow refers to the amount of funds that a company has before interest payments and other obligations are met. It is calculated as; Unlevered free cash flow = EBITDA – Capex – Working capital – Tax.
  • Levered free cash flow is a more concrete number to use in evaluating a firm as levels of debt are important in understanding the company’s risk of bankruptcy.
37
Q

How do we establish the wacc for a company?

A

(The cost of Equity x Equity % of K structure) + (Cost of Debt x Debt% of the K structure)

38
Q

How do we calculate the cost of Equity?

A

Market Equity Risk Premium x Company Beta = Company ERP + RfR = Cost of Equity

39
Q

How do we calculate the cost of Debt?

A

RfR + Borrowing spread = Gross CoD x (1-T)

40
Q

Describe the Parbrai multiple for no growth and growing companies?

A

For no growth companies use 10x CF + excess capital

For growth companies use 12-15x CF + Excess Capital

Excess Capital = Book Value – Fixed Assets – Goodwill – Working Capital Needed for Operations (2% of Sales)

41
Q

Why do stock multiples expand?

A

Multiples Expand because:

The market has just been in a panic
investors believe that the stock will grow faster
biz model is improving

42
Q

Why do stock multiples contract?

A

Multiples Contract because:

market moves to panic
investors beleive that growth will be slower
biz model is deteriorating

43
Q

Talk about the difference between Book values for assset intensive versus service firms…

A

For an asset-intensive firm like a manufacturer or a railroad, BV will represent the bulk of the assets that generate revenue. But for a service firm or tech co, the revenue generating assets are the people, ideas and processes, none of which are generally contained in the BV.

44
Q

What types of competitive advantages are not included in Book value.

A

Cost advantage can result from several factors, including lower labor costs, higher levels of productivity, access to lower cost raw materials, or economies of scale through high-volume production.

Differentiation
1) superior performance, 2) higher quality, 3) lower maintenance costs or 4) Niche customer service offering, 6) Reputation or brand image – factors that give customers the confidence to buy their products or services 7) Uniqueness of product or service.

45
Q

Warren looks for both a high return on equity/capital and he also wants……

A

it to be consistent because this points towards a durable competitive advantage.

46
Q

What is the average ROE of an American company over the last 50 years?

A

Its about 12%.

47
Q

What return metric should we use for Banks?

What is good versus great?

What is key?

A

ROA - above 1% is good and above 1.5% is great

Consistency is key to durability of CA.

48
Q

Why does Warren not like large long term debt?

A

Because it makes it hard to survive a recession or negative event.

49
Q

What doesn’t Warren use to evaluate a companies financial strength?

What measure does Warren use and why?

A

He doesn’t use debt/equity because he thinks that a companies assets aren’t a great source of funds to retire a companies long term debt in bankruptcy.

He likes to look at a companies earnings and see that it would take less than 5 years of net earnings to pay off total long term debt.

50
Q

Using debt to acquire another company is only sensible when the other company has a xxxxx xxxxx?

A

competitive advantage. Else the acquisition might dilute the acquirors competitive advantage.

51
Q

From Warren’s perspective, what is the beauty of a company buying back its own shares?

A

If the company paid out earnings as a dividend, then Warren would have to pay 30% tax on that.

If it retains the dividend, but instead uses the capital to buy back its own stock, it is effectively increasing Warren’s overall ownership in the company, if he does not sell into the buyback.

52
Q

How does Warren compare a stocks forward earnings profile versus bonds to judge value?

A

He adds up all his estimated cumulative 10 year forward earnings and then compares to the 10 year income he would have generated from investing in bonds.

Assumptions: Say bonds trade at 6%. 10 yrs of forward earnings would generated $24.88. The price of the stock is $88. 10 yrs of bonds at 6% = $52.

$88/ps * 0.06 = 5.28 pa x 10 = $52.8 for holding bonds vs $24.88 for holding the stock.

53
Q

why is the purchase price important in evaluating a stock?

A

Because the purchase price helps to determine the ultimate compound annual growth rate of our investment over time.

54
Q

Using Warren’s concept of an Equity/Bond, what is his initial rate of return?

A

Current EPS/Stock price

ie 2.77 / 29.50

55
Q

What is the second part of Warren’s equity/bond concept?

A

As well as the initial yield, warren determines that the earnings growth of the company represents an increasing coupon over time. If the initial yield is 6% and on top of that the company is growing earnings at 10%pa, Warren sees this as a much more attractive proposition that a 10 year bond paying a static 5% yield.

In essence, we can see this as a bond paying 6% in Y1, 7% in Y2, 8% in Y3 and so on.

56
Q

Warren likes to calculate the 5yr and 10y gth rate of earnings as it is?

A

A good indication whether mgmt’s near term performance has been inline with the long term.

57
Q

What differentiation is neccesary when comparing the yield on a Treasury bond versus the EPS from a company?

A

the return on treasury bonds is a pre income tax return, and the net earnings figure of a corporation is an after corporate tax return.

58
Q

For a company with a durable competitive advantage, what is one way Warren would calculate a future stock price?

A

He would look at the 10 yr eps growth and the 10 yr average PE. He would then project earnings forward 10 yrs from today at the 10 yr eps growth rate. Then take that figure and times by the average 10 yr PE to get an estimated stock price in 10 yrs time.

59
Q

Having calculated the future stock price, how would Warren estimate the cagr return?

A

He would put the future stock price in the calculator as the FV, N=10, and PV as the present stock price and calculate i, the rate of return over that period.

He likes to acheive a minimum 15% ROR and so this would be a yardstick for whether the price today was attactive enough.

60
Q

How can valuation multiples impact the CAGR of your investments?

A

If you buy a stock on 2x BV or 20x PE and it collapses to 1x BV or 10x PE, the underlying growth will not be as apparent.

The reverse is true as well.

61
Q

What did Ben Graham think was the key of the analyst?

A

To estimate the underlying earnings power of the company.

62
Q

I feel that the real genius of Warren Buffett is…?

A

I find that a lot of investment analysis start by looking at what looks like a low price in relation to current earnings and then calls those cheap or attractive.

I think the real Genius of Warren Buffett is his very deep understanding of durable competitive advantage and how that leads to significant long-term earnings power.

Fundamental Analysis (6 decks)

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